Global bond yields are responding, without exception, to the spectre of higher and longer-lasting inflation. Inflation pressures remain broad based and have only been made worse from the impact of the Russian/Ukrainian war on commodity prices and supply chains.
Fortunately, consumer spending remains buoyant and supportive of further economic growth in 2022. A strong jobs market, pent-up demand and above average savings due to Covid are all helping – but for how long? Recent consumer sentiment surveys are not positive in this regard – most developed countries surveys point to consumer weakness ahead. How this develops will heavily depend on the actions of central banks in their efforts to get inflation back under control.
The chart below shows the Fed fund rate vs inflation since the late 1960’s. The experience has been that it is only possible to drive inflation sustainably lower by raising rates to above the level of inflation and keeping them there for an extended period. If the FOMC decides inflation will not moderate on its own, the first step would be to take the fed funds rate above the inflation rate. The core PCE inflation rate is ~5% y/y currently. That is a big step! The Fed is now likely in a “tighten until something breaks” mode. The key question remains: will it be inflation or economic growth that breaks first.
Source: Strategas Research Partners
The above news does not make happy reading for the general equity markets which remain at very high valuations (more than 20 times earnings). The chart below shows where valuations will be heading in a higher inflation environment – down.
Source: Strategas Research Partners
As shown a 12.1 times earnings multiple would be more in line with current inflation levels. The world is making a decisive shift away from the zero interest rates of the past ten years. Normalisation will follow. This simply means that the popular momentum stocks where valuation did not matter will come under pressure. On the other hand a value portfolio (ours is currently around 10 times earnings) is still cheap even under a worst case 6-8% inflation level.
As we keep repeating – for those investors looking ahead to the next ten years, as opposed to the last ten, a value based investment strategy seems by far the most sensible option.
ABOUT THE AUTHOR
David Williams (1970) is responsible for the investment policy of Mpartners. After a brief career in diplomacy with the Ministry of Foreign affairs in Barbados, David joined Insinger de Beaufort asset management in 1997 and became a director in 2002. He was responsible for the investment team and the investment funds (long-only and hedged). His specialism is European equities. David holds a B.A. (Hons) from the University of Kent, an M.Sc. from the London School of Economics and an M.B.A. from Nijenrode university.
